Everyone's looking for sound investments with high rates of return. Preferred shares may be overlooked because their price doesn't change much. However, they're attractive because preferred shares are promised minimum dividends that must be paid before the common shares'. Figuring your initial return allows you to either estimate how much you're going to make if you buy the shares or to actually calculate how much money you've made since you made the purchase.
Preferred Stock Return Components
Preferred stock doesn't go up and down as much as common stock because its value is based on the promised dividends. Instead, the preferred stock price tends to move as the required return rate changes. Preferred shares pay a dividend based on a percentage of the face value of the preferred shares. For example, no matter how much you pay for a preferred stock, if it has a face value of $20 and pays a 5 percent dividend per year, you receive $1 per share in dividend payments. So, if you expect a 5 percent return, $20 is the price you'll pay for it. However, if the market requires a 6 percent return from the stock, the price goes down to $16.67 because that way when you receive a $1 dividend payment, that represents a 6 percent yield based on the price you paid for it.
To figure the raw return on your initial investment of preferred stock, subtract the price you paid for the shares from the current price. Then, add the dividends you received per share you bought. Finally, multiply the result by the number of shares you bought to figure the raw return. For example, say you bought 200 shares of preferred stock for $14, they're now worth $14.50 and you've received $1 in dividends. Subtract $14 from $14.50 to get 50 cents. Then, add the $1 per share dividends you received to get a $1.50 gain per share. Finally, because you bought 200 shares, multiply 200 by $1.50 to find your return is $350.
A raw return alone, whether it's $350 or $350,000, doesn't tell you all that much about the success of an investment other than you made a profit, because you don't know how much was invested to get that return. For example, while $350 might sound paltry compared to $350,000, if you only invested $1,000, $350 is a significant return. To accurately compare returns relative to your investment, divide the return by the initial investment and multiply by 100 to figure the return as a percentage. For example, if you earned a return of $350 by investing $2,800, divide $350 by $2,800 to get 0.125. Then, multiply by 100 to get a return of 12.5 percent.
Annualized Return Rate
While the percentage is a better at giving you context for the return, it still doesn't include the time element. Obviously, the longer you hold a stock, the larger the return you expect. So, to compare returns on preferred stocks you've held for different periods of time, add 1 to the percentage return expressed as a decimal. Then, raise the result to the power of 1/T, where T is the number of years you've held the stock. Finally, subtract 1 and multiply by 100 to figure the annualized rate. For example, if your 12.5 percent return to a year and a half to generate, add 1 to 0.125 to get 1.125. Then, raise 1.125 to the 1/1.5 power to get 1.082. Finally, subtract 1 to get 0.082 and multiply by 100 to find your annualized return on the preferred stock is 8.2 percent.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."